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How High Is Too High For The Yen?

Despite having weak inflation (at only 0.9%), Japan’s economy is on the ascent in terms of GDP growth, retail sales, consumer sentiment and corporate profits. This only increases the possibility that the Bank of Japan finally considers tapering its decade-old policy of asset purchases, which is distorting the equity and bond markets.

This policy is unsustainable. Through its annual purchases of 80 trillion yen in government bonds, the Bank of Japan owns over 11% of all government debt. And through its purchases of Japanese stocks, it owns 71% of all Japanese equity exchange-traded funds, acting as the largest holder in 55 firms of the nation’s bellwether Nikkei 225 index.

As the world’s major central banks shift towards tighter monetary policies, Japan’s central bank remains the farthest behind. This also means that it faces the scope of policy normalization i.e. reducing asset purchases, whose impact must be rising bond yields.

Dwindling Carry-Trade

It is for the above reason that the Japanese yen has strengthened despite the broad advance of global bond yields. Over the past 10 years, markets have grown accustomed to the yen-carry trade, driving the yen lower during improved risk appetite and rising bond yields abroad, as Japanese investors chase returns overseas due to ultra low or no yields on most financial instruments at home.

Increased Hedging

The role of Japanese insurance companies and pension funds in slowing the carry trade has been crucial over the past year—especially against the USD. These investors, who directed hundreds of billions of dollars in US-denominated assets have begun raising their hedge against the risk of their interest earnings losing value when converted back to yen. The rise in the hedge ratio of Japanese funds and insurance companies is perhaps the most significant and least discussed phenomenon in current yen strength.